Why the Outlook has Brightened for Money Market Funds

Amidst all the chatter over the pros and cons of the various
government sponsored programs designed to cure the financial
markets, it is worth noting that some of the targeted programs have
produced positive results by any standard. The Treasury
Department's Temporary Guarantee for Money Market Mutual Funds
(Temporary Guarantee program), the Fed's Asset Backed
Commercial Paper Money Market Fund Liquidity Facility (AMLF),
and Money Market Investor Funding Facility (MMIFF) have
largely achieved their objectives. These programs stemmed a
potentially devastating run on the money fund industry, instilled
confidence across the retail and institutional investor populations
and restored an active, liquid market for both issuers and buyers
of high quality, short-term corporate debt.

On September 16, the Reserve's Primary Fund became only the second
fund in history to "break-the-buck", resulting in close to $400
billion being pulled from prime money funds over the following two
weeks. Although much of this money moved to government and Treasury
funds, $123 billion left money funds altogether. Realizing that a
sustained exodus from money funds would negatively impact far more
than just the funds' investors, the Treasury Department stepped in
to insure these assets against loss through the Temporary Guarantee
program. The Treasury Department is well aware of the importance of
money funds to the global economy. Companies rely on money funds to
buy their short-term debt in order to finance payroll and meet
other obligations. In short, money funds allow many of the most
critical contributors to the global economy to stay open for
business.

Since the announcement of the Temporary Guarantee program, assets
have started flowing back into money funds. According to the
Investment Company Institute, as of February 11, 2009 total money
fund assets have climbed to $3.9 trillion from $3.4 trillion on
October 1, 2008. Total prime fund assets have climbed from
$1.7 trillion to $1.9 trillion over the same time period. While
investors' confidence in money funds may have been justifiably
shaken, government support as well as the support provided by many
of the funds' sponsors has restored that confidence considerably.

But what does the future hold for the money fund industry? In the
wake of the Reserve buck-breaking episode, a report issued by the
Group of 30 - whose members include Paul Volcker among others -
recommends a dismantling of the money fund industry as we know it.
Their idea is to transform money funds into "special purpose banks"
where the funds would be regulated like banks and deposits would be
insured much like bank accounts. Banks would certainly view this
proposal as a threat to their ability to attract deposits. Based
upon the uproar voiced by banking industry groups when the
Temporary Guarantee for Money Market Funds program was announced,
it is hard to envision a quiet acceptance of a more permanent and
dramatic proposal.

Some of the Group of 30's recommendations include a requirement
that money funds "only offer a conservative investment option" and
that funds should "clearly be differentiated from federally-insured
deposits offered by banks. . .with no explicit or implicit
assurances that funds can be withdrawn on demand at a stable NAV."
But in the vast majority of cases, money funds have abided by these
recommendations since they were first created over 30 years ago.
The run on money funds was not due to lack of regulatory oversight,
but rather was a result of widespread fear among investors.

Dismantling the money fund industry seems highly unlikely given the
critical role it plays in providing liquidity and stability to the
global economy. As evidence of demand for its products, the
industry continues to expand with multiple examples of new money
funds filing with the SEC over the past 90 days. With that in mind,
what actions can fund sponsors and regulators take to ensure money
funds remain a viable option for investors and a profitable
business for sponsors?

Fund Company Actions

One of the issues facing fund sponsors has been the large shift out
of prime funds and into Treasury funds where fees are often being
waived to avoid negative yields. In order to relieve the pressure
on these funds, sponsors will need to encourage flows back into
prime funds, where the fees are not threatened by exceedingly low
gross yields. To accomplish this, investors will need to be
comfortable with the holdings in prime portfolios. Investors will
eschew holdings enveloped in headline risk, and esoteric
descriptions like Structured Investment Vehicles. Now more than
ever, prime fund managers must place a premium on investments that
display a high degree of liquidity in any market environment. Ten
to twenty percent in overnight holdings will not be unusual.

Holdings in industrials, government agencies and even Treasuries
(typically shunned by prime funds) will likely comprise larger
percentages of many prime fund holdings. With a few domestic
exceptions, exposure to financials will likely decrease, especially
in the European and Asian banks. As the Treasury continues to flood
the market with new issues, the spreads between government
securities and the highest quality industrial commercial paper will
continue to compress. In this market, a prime fund manager looking
at a ten or twenty basis point spread between a government and a
corporate is more likely to choose the government for the enhanced
safety and liquidity. It will not be uncommon to see government
holdings ranging anywhere from ten to thirty percent in prime
funds.

To the extent debt under the Temporary Liquidity Guarantee
Program (TLGP) is issued in the money fund eligible maturity
range, there should be a demand for it. This program allows
participating financial institutions to issue debt with a
government guarantee, essentially making it the credit equivalent
of a Treasury. To date, most of the debt issued under this program
has been longer term and thus not eligible for money funds.

Regulatory Actions on the Horizon

Many in the money fund industry are speculating about potential
changes to SEC Rule 2a-7, which regulates money market funds. As
early as last May, SEC staff began considering a proposal to remove
any explicit reference to nationally recognized statistical
ratings organizations (NRSROs) from the rule. The rationale
being that money funds relied too heavily on credit ratings, and
not enough on their own due diligence into the securities they
purchased. This proposal seems urealistic. It would be difficult to
apply the high credit standards Rule 2a-7 seeks without some
reliance on a third party agency at least as a starting point. A
likelier outcome would be the inclusion of more specific, stricter
language about internal research. In its present form Rule 2a-7
specifies that an independent minimal credit risk determination "
must be based on factors pertaining to the credit quality in
addition to any rating assigned to such securities by an
NRSRO. " Establishing more specifics in this section of the
rule would hold fund sponsors more accountable for their investment
decisions.

Other potential regulatory actions might involve changes to some of
the maturity restrictions contained in Rule 2a-7. Currently, any
fund regulated under the rule cannot have a weighted average
maturity (WAM) greater than 90 days. A shorter WAM reduces interest
rate risk further and thus provides more protection to investors.
Another version of this idea would be to tighten the requirements
around variable and floating rate securities. Today, funds may deem
the next interest rate reset date of these securities (which can be
as short as one day) as the maturity, as opposed to the security's
actual final maturity which is often much longer.

Regulators might choose to mandate specific liquidity requirements.
For example, the rule could stipulate that a certain percentage of
the fund's portfolio must mature between one and seven days.
Although a requirement like this might be viewed as overly
intrusive by some fund managers, it does not seem entirely
implausible given how much of the recent turmoil was liquidity
related as opposed to a deterioration in underlying credits.

While it is still unknown if and when any regulatory changes will
impact the money fund industry, it seems reasonable to expect
changes to occur.

Conclusion

We believe that despite the daunting market challenges faced by the
money fund industry, there is reason for optimism about the future.
Given the recent growth in institutional as well as retail money
fund assets, it seems clear corporate treasurers remain bullish
about the industry. Corporate cash managers gradually seem to be
emerging from their "Treasury-only" strategies. With recent
declines in Treasury fund assets corresponding almost exactly to
increases in prime fund assets, dissatisfaction with abysmally low
Treasury yields seems to be taking root. If more transparency into
prime holdings combined with meaningful regulatory changes is on
the horizon, this trend should continue. It is worth remembering
that aside from the situation with the Reserve's Primary Fund, no
other money fund investor has lost a penny in principal throughout
this financial crisis. While other supposedly "safe" investment
options like auction rate securities and "enhanced" cash funds have
wreaked havoc on investors, money market funds continue to serve as
the safe haven of choice for investors across the globe.

Amidst all the chatter over the pros and cons of the variousgovernment sponsored programs designed to cure the financialmarkets, it is worth noting that some of the targeted programs haveproduced positive results by any standard. The TreasuryDepartment's Temporary Guarantee for Money Market Mutual Funds(Temporary Guarantee program), the Fed's Asset BackedCommercial Paper Money Market Fund Liquidity Facility (AMLF),and Money Market Investor Funding Facility (MMIFF) havelargely achieved their objectives. These programs stemmed apotentially devastating run on the money fund industry, instilledconfidence across the retail and institutional investor populationsand restored an active, liquid market for both issuers and buyersof high quality, short-term corporate debt.

On September 16, the Reserve's Primary Fund became only the secondfund in history to "break-the-buck", resulting in close to $400billion being pulled from prime money funds over the following twoweeks. Although much of this money moved to government and Treasuryfunds, $123 billion left money funds altogether. Realizing that asustained exodus from money...Read More